By Leika Kihara and Daniel Leussink
TOKYO (Reuters) - The Bank of Japan kept monetary policy steady on Thursday as expected but gave the strongest signal to date that it may cut interest rates in the near future, underscoring its concern that overseas risks could derail a fragile economic recovery.
BOJ Governor Haruhiko Kuroda said the central bank still had room to take already negative rates even lower to prevent global uncertainties from hurting the world's third-largest economy.
"The chance of the economy losing momentum to hit our price (inflation) target hasn't escalated. But we need to scrutinize developments as overseas uncertainties are heightening," Kuroda said.
"It's still possible for the BOJ to deepen negative rates," he told a news conference after a policy view, adding the costs of doing so would not deter him from taking short-term rates beyond the current -0.1%.
The decision came hours after the U.S. Federal Reserve lowered rates again but signaled a pause in further cuts unless the economy took a turn for the worse.
The BOJ, which has far less policy ammunition left than the Fed, maintained its short-term rate target at -0.1% and that for the 10-year bond yield at around 0%.
It also maintained a pledge to buy government bonds so its holdings increase at an annual pace of roughly 80 trillion yen ($736 billion).
But the BOJ modified its forward guidance - a signal central banks give to markets on future policy moves - to indicate more clearly its readiness to cut rates if needed.
"The BOJ expects short- and long-term interest rates to remain at present or lower levels as long as needed to pay close attention to the possibility that the momentum toward achieving its price target will be lost," the central bank said in a statement announcing its policy decision.
That compared with the previous language that committed to keep "current ultra-low rates for an extended period of time, at least until the spring of 2020."
Kuroda said the new guidance was aimed at clarifying to markets the BOJ's readiness to ramp up stimulus.
"The BOJ wanted to maintain expectations among the market that further easing is still a possibility," said Masaaki Kanno, chief economist at Sony Financial Holdings.
SIDE-EFFECTS LOOM
The BOJ last month said it would use its October rate review to look more thoroughly at overseas risks, stoking market speculation of immediate action.
Conditions have improved since then. The yen has shown some signs of steadying recently, taking pressure off the BOJ to prevent an unwelcome yen spike from hurting exports.
While inflation is still well below the BOJ's 2% target, data this week showed industrial output rebounded in September and retail sales jumped the most in over 5 years.
"Overseas economic risks are heightening. But the negative impact hasn't spread much to the domestic demand," Kuroda said.
But the outlook remains murky. Exports continue to contract and a sales tax hike this month has raised concerns the economy could tip into recession.
In fresh quarterly projections, the BOJ cut its inflation forecasts as falling fuel costs and soft household spending weigh on price growth.
Kuroda said the new forward guidance did not mean the BOJ was ruling out means besides rate cuts, such as ramping up asset buying or printing money more aggressively.
But he said the best way to stimulate the economy was to lower short- to medium-term borrowing costs, signaling that deepening negative rates was the most likely next option.
Excessive declines in super-long yields, on the other hand, were undesirable as they could dampen household mood by eroding returns of pensions funds and insurance firms, Kuroda said.
"If the yield curve flattens too much, we can tweak our market operations" such as further slowing the BOJ's purchases of super-long bonds, he said.
S&P Global (NYSE:SPGI) Ratings warned on Tuesday that Japanese regional banks will see core operating profits fall by 21% if the BOJ deepens negative rates.
"The BOJ doesn't have many tools left to ease policy so it probably wanted to save them for now, particularly with fading expectations of a Fed rate cut seen keeping yen rises at bay," said Izuru Kato, chief economist at Totan Research.
"If risks do not heighten enough to prod the Fed to ease in December, the BOJ could hold off on action that month as well."
The BOJ's next rate review is Dec. 18-19.